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Where China Hides Its Debt

Victor Shih is a professor of political science at Northwestern University who spends his days scouring the Chinese Internet, looking for signs of financial trouble. Shih explores obscure Chinese government sites for announcements of loan agreements between China's state-owned banks and local investment companies (LICs). These companies borrow on behalf of local governments whose own ability to borrow is legally limited. Officially, there are more than 8,000 LICs. Beijing encouraged their development over the past two years as a way to disseminate funds quickly to projects.

Now, Shih is worried that the LICs have borrowed more than they can pay back. Chinese officials share his concern. "The soundness of the banking sector is being tested," Liu Mingkang, the top bank regulator, warned in June. He cited lending to "local government financing platforms"—or the LICs—as one of the big risks the banks face.

Many of the LICs have borrowed heavily to back the building of roads, railroads, and power plants, as well as hotels, convention centers, office buildings, and more. While some LICs have gotten land from local governments that they can use as collateral, many banks must rely on pledges from local city halls that the loans the LICs secured will be repaid. Shih figures outstanding LIC debt at the end of 2009 was $1.68 trillion—34 percent of China's gross domestic product. "A lot of this money is being invested in money-losing infrastructure projects [as well as] real estate," says Shih. Western investment firms are wondering what impact the LICs will have on Chinese banks if they cannot pay back the bulk of their debts. "Unfortunately, this smells like China's last banking crisis," says Shen Minggao, an Asia-Pacific economic analyst with Citigroup (C).

Figuring out what projects the LICs have financed and how healthy they are is hard. Shih says LICs in the western city of Yinchuan, the capital of Ningxia autonomous region, have helped bankroll a building spree. New luxury villas and high-rise residential complexes, as well as a huge new soccer stadium, adorn the city. A science and technology center, a museum, and a library each occupy several football fields' worth of turf, while an almost-finished skyscraper resembles New York's Empire State Building. It's pretty ambitious for a region that depends on cash transfers from Beijing for 70 percent of its total revenues. Shih estimates Ningxia's debt at $15 billion—75 percent of the region's economy. "A soccer stadium in the middle of nowhere is not going to generate much cash flow," he says. "Without massive central government subsidies, I think many of these projects will not generate enough cash even to pay interest on their loans."

Local officials say there's no problem, and that a healthy mix of bank funds, corporate bonds, grants from Beijing, and investment from state enterprises has pumped billions into Ningxia. "This shows how much importance the central government places on developing the west, and Ningxia benefits from that," says Shao Xiaowen, an official from the local development and reform commission.

In June, China's State Council ordered local governments to guarantee that their investment vehicles were able to repay their debts. The localities were also told to finish projects under way before starting new ones. "The biggest concern is that harsh implementation of these new rules would leave many [local governments] with half-finished projects and no prospect of servicing their debts," wrote Mark Williams, senior China economist at Capital Economics, a London consultancy, in a July 8 report.

Beijing could also opt to ignore its own edicts and stick with easy lending. In early July central government officials said they would continue the Develop the West program for 10 more years and budgeted $101 billion for 2010 alone. China is loath to tap the breaks too suddenly, particularly in the west, home to migrant workers, peasants, and restive minorities. Risk a bank crisis by lending too freely? Or court recession and upheaval by cutting off the funds? It's a hard choice.

The Bottom Line: Special financing companies in China have borrowed almost $2 trillion. Concerns are rising about their ability to pay it all back.